Though we are not out of the woods yet, the time is ripe for bankers and policymakers to consider how to achieve the right private-public sector balance in the new financial services world that is taking shape.
No one believes the government should be in the business of managing banks. Nor does anyone want to let their guard down if it means reliving the debacle we have just experienced. We are in for more difficult decisions as an industry and as a nation.
The Obama administration has correctly put the emphasis on the question of how to resolve large troubled institutions. I don't believe we can continue with the ad hoc process that brought us a mishmash of approaches for Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, American International Group and others. The fallout from this litany of failures and near-misses tells us that we require a process to manage the way in which large, interconnected financial companies fail, whether they have a bank at the core or not.
If the hard questions are not confronted and we are left with a "too big to fail" system in which government support is expected in crises for some institutions while others are left to twist in the wind, the implications could be devastating. Such an approach could further undermine our already-battered free market capitalist system and make it impossible to dismiss the claim that "too big to fail" institutions are tantamount to public utilities.
At the heart of getting government out of the private sector is differentiating between companies that misbehaved or simply failed to perform adequately and those that were fundamentally successful but, in a time of extreme crisis and unusual market gyrations, got tarred with the same brush as their weaker brethren.
The successful should have the latitude to be innovative and bring new products and services to customers, businesses and individuals to enhance their well-being and the economy as a whole. Those that fail should be put out of their misery.
This is not some sort of vulgar need for retributive justice — allowing failed institutions to fail and not become wards of the state is at the heart of the way a free market system disciplines the private sector to operate better. If a company is deemed "too big to fail," gets bailed out when problems arise, gives executives lavish golden parachutes even if it fails and has to be put on governmental life support, where is the discipline going to come from?
One reason the markets are frozen and have been slow to thaw is that there is no resolution mechanism for large, interconnected financial institutions and no clear way to differentiate between the strong and the terminally ill. Ad hoc decision-making has proved enormously expensive and has undercut market confidence.
Furthermore, admitting that institutions are "too big to fail" creates mountains of moral hazard while unbalancing the financial sector vis-a-vis community banks. Thus a reliable resolution mechanism for even the largest financial institutions should be a priority. It is a fair question to ask ourselves from a public policy perspective: If an institution is too big for the public sector to resolve, should we allow the institution to get to that size?
In this same vein — preventing private institutions from becoming wards of the state — the government should encourage, not discourage, financial firms to pay back Troubled Asset Relief Program funds and move out of other assistance programs.
The government — we taxpayers — should be compensated fairly but not excessively for the umbrella that was used to protect some financial institutions from harm. The biggest compensation to taxpayers is not interest or equity returns from the injection of government funds. It comes from the re-emergence of vigorous institutions capable of standing on their own feet, paying taxes and providing good jobs. In this regard, government infusions that come with excessive interest charges, which cannot be paid back or cause financial firms to take undue risks to the money back, are not productive.
The institutions that should be penalized are those that cannot repay government funding after a reasonable period — a number of years after markets reopen, assuming fair charges are applied for the financing. When we have institutions that cannot repay government funding, we should carefully consider whether we should resolve them. Similarly, it is not productive for the government to become an executive suite paymaster.
Certainly there have been abuses — beggaring the company and then walking away with a huge paycheck — and these must stop. Aligning compensation with the long-term interests of the company and its stakeholders makes sense. It also wise to put clearer responsibility on board compensation committees to ensure that executives are fairly compensated, and that their compensation is in the interest of the company.
But when the government feels it has to intrude into the private sector to the point that it must set executive pay for some companies, the question that must be asked is whether such companies should continue to exist as private entities.
It is vital to the future of large financial enterprises to resolve the "too big to fail" or "too big to be taken off life support" problem. If large financial enterprises are wards of the state, the executive compensation issue will come up repeatedly. How could it not, in a society where democratically elected governments set pay scales for teachers as low as $35,000 even in well-to-do communities, and when anger toward the banking industry is at an all-time high?
As I have said before, government largesse will always come with strings attached, and those strings will become more constraining over time.
To achieve the fully vigorous financial sector we need for a strong economy, the government should facilitate, not resist, the repayment of crisis funding, returning firms fully to the private sector as quickly as possible, and we need to develop a resolution mechanism that is sufficiently robust to deal with the largest financial firms, whether bank-related or not.